Types of Business Entities: The Basics You Should Know
Of all the choices you make when starting a business, one of the most important is the type of legal entity you select. Your decision affects how much you pay in taxes, personal liability and the amount of recordkeeping required.
In the early going of any business, you will invest money. Your investment is potentially a tax deduction, and it will greatly reduce your personal taxable income. This, in turn, may increase your tax refund. In addition, the government is always changing the tax code to benefit the new business owner. The most common types of entities are sole proprietorships, partnerships, corporations, limited liability companies (LLCs) and S corporations. The answer to “What structure makes the most sense?” depends on your individual circumstances. Here are the basics about each:
1. Sole Proprietorship
A sole proprietorship is the most common form of business organization. It’s easy to form and offers complete control to the sole owner. Sole proprietors can operate any kind of business, including a shop or retail trade business, large company with employees, home-based business or one-person consulting firm. However, it must be a business, not an investment or hobby.
Generally, as a sole proprietor you would file Schedule C, Profit or Loss from Business, or C-EZ, Net Profit from Business (Sole Proprietorship), with your Form 1040, U.S. Individual Income Tax Return. You combine your net business income or loss with your other income and deductions. The IRS then taxes you at individual rates on your personal tax return. However, in addition to income tax, you must also pay self-employment tax of 15.3% on the net income reported on Schedule C.
Generally, as a sole proprietor you are personally liable for all financial obligations and debts of the business. In addition to the personally liability, your personal assets may be at risk for legal claims made against the business. No major business in this
country operates as a sole proprietor and for good reason.
2. Partnership
A partnership is the relationship between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
Partnerships file Form 1065, U.S. Return of Partnership Income, to report income and expenses. The partnership passes the information to the individual partners on Schedule K-1, Partner’s Share of Income, Deductions, Credits, Etc. (known as
pass-through or flow-through). Each partner reports his or her share of the partnership net profit or loss on his personal tax return. General partners must pay self-employment tax on their net earnings from self-employment assigned to them from the partnership.Similar to a sole proprietorship, the partners are personally liable for all debts of the business.
3. Corporation
A corporate structure is the most complex of any business structure. It requires complying with more regulations and tax requirements. Corporations are formed under the laws of each state and are subject to corporate income tax at the federal
and, generally, at the state level. Any earnings distributed to shareholders as dividends are taxed at individual tax rates on their personal tax returns. When you form a corporation, you create a separate tax-paying entity. Unlike sole proprietors and partnerships, income earned by a corporation is taxed at the corporate level using corporate tax rates.
A corporation files Form 1120, U.S. Corporation Income Tax Return, or 1120-S, U.S. Income Tax Return for an S Corporation. If a shareholder is an employee, he pays income tax on his wages, and the corporation and the employee each pay one half
of the social security and Medicare taxes. The corporation can deduct its half. A corporate shareholder pays only income tax for any dividends received.
The corporation is an entity that handles the responsibilities of the business. Like a person, the corporation can held legally liable for its actions. If you organize your business as a corporation, you are generally not personally liable for the debts of the corporation.
4. S Corporation (Small Business Corporation)
An S corporation has the same structure as a standard corporation. The difference is the corporation files an election on Form 2553, Election by a Small Business Corporation, and the IRS treats the entity differently for federal tax purposes. Generally, an S corporation is exempt from federal income tax.
An S corporation files Form 1120-S, U.S. Income Tax Return for an S Corporation. Similar to a partnership, the income flows through, and the shareholders report it on their individual returns. As a shareholder, you must pay tax on your share of corporate income, whether or not it is actually distributed. One main benefit of the S corporation is the potential minimization of self-employment taxes, which can amount to 15.3%.
There is generally limited liability for corporate shareholders.
5. Limited Liability Company (LLC)
LLCs are popular because, like a corporation, owners generally have limited personal liability for the debts and actions of the LLC. Like a partnership, an LLC provides management flexibility and pass-through taxation. Owners of an LLC are known as members. Members may include individuals, corporations, other LLCs and foreign entities. Most states also permit single-member LLCs (those having only one owner).
Which structure best suits your business? One form is not necessarily better than any other. Each business owner must assess his or her own needs. In addition, because your choice of a business entity is so important, always consult with a tax professional before you proceed forward in your new business.
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By Gary J. Milkwick, CPA, MBA
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This article first appeared in the September 2008 issue of the MarketingDotCom newsletter. You can get a free copy of the latest issue for the price of shipping at http://the7figuresecrets.com